Vanguard knows when to fold ’em

Commentary: Put underachieving fund managers on the cutting block

BOSTON (MarketWatch) — Savvy investors always try to learn from the pros, so when Vanguard Group axes a prominent money-management firm, it’s a teaching moment.

Vanguard announced on Thursday that it had kicked AllianceBernstein Holding LP off the portfolio management teams of Vanguard Windsor
VWNDX, +0.64%
Vanguard International Value
VTRIX, +0.03%
and Vanguard Global Equity
VHGEX, +0.44%
funds.

It’s a move that most observers felt was long overdue. Indeed, Vanguard had whacked AllianceBernstein from underperforming Vanguard US Growth Fund
VWUSX, +0.64%
in 2010.

Unlike fund companies that keep all of the money management in-house, Vanguard hires sub-advisors to run some or all of the assets in some of its actively managed portfolios.

Report card

In effect, that makes the company a bit like the average fund investor, in that Vanguard must size up managers, gauge what skills they could add to the mix, and monitor performance to decide whether to keep them or move on.

Since the regular criticisms of typical fund investors are that they only buy what’s hot and sell too quickly when performance turns, it’s worth seeing how Vanguard made its decision.

For starters, the company did not mention underperformance as a reason to end its 10-year relationship with AllianceBernstein
AB, +1.36%
, although it’s hardly a secret that the sub-advisory firm has been struggling.

Vanguard also didn’t mention that AllianceBernstein’s replacement on Windsor, Pzena Investment Management, hasn’t posted such great performance lately. (It has been noticeably worse than the results for the other managers who were used to replace AllianceBernstein on the other funds.)

“They will never tell you it’s performance, but that’s what it was,” said Dan Wiener, editor of the Independent Advisor for Vanguard Investors. “But there’s a lesson here for investors, and it’s that you don’t want to be too quick to pull the trigger too early or too late on a manager. There’s no one right answer as to whether you give managers three years or five years, so the really important thing is to have some internal measures for when it’s time to make a change.”

Science and art

Vanguard critics were surprised that the firm did not jettison AllianceBernstein completely in 2010, but keeping the firm on actually shows part of Vanguard’s thinking on relationships with managers.

Vanguard started working with two different sub-advisors that eventually merged into AllianceBernstein; the growth team fired in 2010 was from the old Alliance Capital side of the business, whereas the managers dumped now were value managers from the old Bernstein side of the firm.

Dan Newhall, partner in Vanguard’s Portfolio Review Group, said the firm views each management decision as distinct, but then fits everything into an overall framework.

“In our opinion, there is both a science and an art to deciding which managers you want to work with,” Newhall said. “It’s hard to generalize, but you do want to continually oversee and assess not just the firms that are running your money, but the teams that you are working with.

“You could own two funds with one fund company, really like one of them, but be ready to fire the manager of the second,” Newhall added. “That happens, so I would not suggest anyone generalize and just say ‘Get rid of that firm.’ Judge each fund individually to see if it is doing what you expect.”

Far too often, investors sell funds for the wrong reasons, most notably recent short-term performance or feelings about the market.

Performance matters, but mostly as it relates to other funds in the asset category; a losing fund could be the best in its class, but the asset type is out of favor with the market. Blowing up an asset-allocation plan typically means buying what is hot right now, and is the way most people wind up consistently buying high and selling low.

Other factors include the size of the fund — particularly sudden growth that bloats the assets — changes in investment strategy or management personnel, and an inability to deliver the returns you would expect either from the investment strategy or the asset class.

“We carefully monitor the portfolio,” Newhall said, “to see if it is consistent with our expectations, if it is doing what we expect, if any disappointment has an explanation that is in keeping with what we expected from management, rather than was caused by some sector bet or strategy change that no one anticipated.”

He added: “Performance isn’t the most important thing when evaluating a manager. All deep-value managers have struggled — including the one we just brought in [Pzena]. But if what is important is investing in the category, what matters is that you are working with a manager whose process you understand, and whose results are what you expect. Without that, I think most investors will struggle to stick with a fund for the long-term whenever the market is working against their managers.”

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